MEASURING THE UNFUNDED OBLIGATIONS OF EUROPEAN COUNTRIES

January 22, 2009

Europe is undergoing two major transitions. On the demographic front, many European countries are undergoing rapid population aging as their Baby Boom generations enter retirement, senior citizens live longer and fertility rates remain well below the population replacement level. On the economic front, 15 European countries have adopted the euro as a common currency, eliminating the ability to use monetary policy to achieve country-specific economic goals. Both transitions will place tremendous, conflicting pressures on the domestic national budgets of European countries, says economist Jagadeesh Gokhale.

As a result, all European countries have large unfunded liabilities -- the difference between the projected cost of continuing current government programs and net expected tax revenues. In general:

The average EU country would need to have more than four times (434 percent) its current annual gross domestic product (GDP) in the bank today, earning interest at the government's borrowing rate, in order to fund current policies indefinitely.

At the low end, Spain would need to have almost two and one-half times (244.3 percent) its annual GDP invested.

At the high end, Poland would need to have 15 times its GDP invested in real assets, forever!

No EU government has made the necessary investment, says Gokhale. As an alternative, the next-best option is for these countries immediately to gradually but significantly increase saving and investment. In particular, the average EU country could fund its projected budget shortfall through the middle of this century if it put aside 8.3 percent of its GDP each and every year. Despite this adjustment, a budget shortfall is likely to emerge after 2050, requiring additional fiscal reforms.

What will happen if EU countries do not set aside these funds? Unless they reform their health and social welfare programs, they will have to meet these unfunded obligations by increasing tax burdens as the larger benefit obligations come due, says Gokhale.

Spending already averages 40 percent of GDP today:

By 2020, the average EU country will need to raise the tax rate to 55 percent of national income to pay promised benefits.

By 2035, a tax rate of 57 percent will be required.

By 2050, the average EU country will need more than 60 percent of its GDP to fulfill its obligations.